Note: This paper is originally published in
the Journal of Commerce and Management Thought (http://goo.gl/7htI1W)
in July 2014 edition.
“Wide diversification is only required when investors do not understand
what they are doing.” – Warren Buffett
Investopedia defines
diversification as a technique that reduces risk by allocating investments
among various financial instruments, industries and other categories. It aims
to maximize return by investing in different areas that would each react
differently to the same event.
So can we diversify all the risk
that is there in the investments? If not then what we can diversify and what we
cannot?
There are mainly two types of
risk: Systematic Risk and Unsystematic Risk.
Systematic risk is also called
non-diversifiable or un-diversifiable or market risk. This risk is beyond the
control of individual investments, companies or industry. This risk comes with
factors like interest rate, inflation rates, exchange rates, and political
instability. The concept of systematic risk applies to individual securities as
well as to portfolios. The market or systematic risk cannot be diversified and
hence it is non-diversifiable risk which investors have to accept.
Unsystematic risk is also called
diversifiable risk. It is a risk associated with specific company, industry,
market, economy or country. This risk can be reduced through diversification
and hence it is diversifiable risk. The most common sources of unsystematic
risk are business risk and financial risk. If we invest in various assets then
they will not all be affected the same way by market events.
The below example will help us
clarifying the impact of Systematic and Unsystematic risk.
There are two software companies.
One deals primarily in software services and another with niche product space. Both
these companies export their products or services to overseas market and earn revenue
in American Dollars (USD). Later they get this revenue converted in Indian
Rupees (INR). If exchange rates of USD to INR changes with INR getting
depreciated then both the companies get more INR revenue without making any
business changes while opposite is also true. Here if an investor selects
either of this company then the exposure to exchange rate fluctuations, and
accordingly an impact on the earning on these companies, will remain the same. This
is a systematic or un-diversifiable risk. The risk will not be diversified even
if we select either of these companies.
Now in another scenario, the
product company is developing a software product in the space of Analytics and has
made significant investments towards that. This is a business specific risk. If
the product is successful then it is huge gains otherwise huge losses. This
risk associated only with the product company and not with the market. Hence
this risk can be diversified by selecting another company which may not have a
similar kind of exposure in the product category.
We are clear that company specific
or diversifiable or unsystematic risk can be diversified by allocating
investments among various financial instruments, industries and other
categories. Now if we have to diversify the risk associated within a portfolio
of multiple stocks then how many stocks can help us diversify this unsystematic
risk?
There are several academic
studies available to support the idea of number of stocks to diversify the
unsystematic risk; however, there is no consensus. One such study is conducted
by Frank Reilly and Keith Brown. In their book Investment Analysis and
Portfolio Management, they reported that for randomly selected stocks about 90%
of the maximum benefit of diversification was derived from portfolios of 12 to
18 stocks. In other words, if you own about 12 to 18 stocks, you have obtained
more than 90% of the benefits of diversification, assuming you own an equally
weighted portfolio. There is another study which indicated 30 stocks. Whatever
the number, it is significantly less than all
the stocks in the market.
This set of 12 to 30 stocks will
help you removing more than 90% of the unsystematic risk. But you will still
have systematic risk remaining in the portfolio of stocks. This systematic risk
will give you the same return in the market as if you had bought a passive
market index. If you want to obtain a higher return than the markets, you
increase your chances by being less diversified or have a more concentrated
portfolio. At the same time, you also increase your unsystematic risk and
thereby total risk. Remember, diversification may help us in protecting the
wealth, but concentration will help in building the wealth.
Warren Buffett rightly said that “Diversification is a protection
against ignorance. It makes very little sense for those who know what they’re
doing.”
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About author: Niteen S Dharmawat is an MBA and cleared CFA Level 2,
CFA Institute USA. A firm believer in long-term financial planning, and a 20
years veteran of the stock market, he likes to analyse the economy, and
individual stocks. He also conducts investor education sessions.
He likes reading books/magazines/news papers on the topics as diverse as
general management, technology, investment, fiction, marketing and the Gita.
He is a person who believes that "Everything else can stop but
learning".
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Source:
http://www.investopedia.com